From the Certainty of Efficient Markets has come Moral Hazard!

In my previous post I picked up on a statement in a Dan Solin article.  My concern was that the article appeared to express a level of certainty regarding an investment outcome that to me reflected the type of moral hazard that has, in my opinion, negatively impacted the world financial and economic system, in particular, since the latter half of the 1990s.  This is not to say that moral hazard has not always been a feature of human decision making, just that I believe MPT helped legitimise it.

However, before I go on, I just want to make clear that I have nothing but praise for the IFA line of funds: this is not an attack on IFA funds, which I believe have relevance irrespective of your view of the efficiency or otherwise of world markets.  Management and transaction fees kill performance and elevate risk and there is no place for the vast majority of actively managed funds in this universe, especially if you live in Canada, where high fees are a protected species.      

But, I wish to revert back to the point I was making: if you are making decisions on the assumption that markets are efficiently pricing risk, and that the mean of the distribution of expected returns is going to be positive, then you risk creating a framework in which the certainty of the investment outcome has, to all intents and purposes, been decided.  If you increase certainty of return, you reduce risk, and the discounted present value of future returns increases. But, worse than a more highly valued asset in an efficient market, which may only reduce the order of the positive magnitude, is a more highly valued asset in an inefficient market with outsized, out of equilibrium systematic risks.  

I believe that the greater level of “certainty” that MPT has brought to decision making has endorsed a higher level of systematic risk taking.  MPT helped introduce a level of certainty that simply should not have existed, which obscured the risk being built up in the system.  It created an imbalance in the valuation metric, a ghost in the machine.   

There may indeed be times when the risks to future return are such that a given investor is likely to experience negligible to negative real equity returns over their life expectancy. I think if you are managing assets and liabilities and expectations to boot, you need to be able accept that markets are not guaranteed to produce positive “expected” returns and manage/discount this risk accordingly.  The assumption of efficient markets and expected positive returns does not allow for the management of outsized, out of equilibrium risks.

If risks are not being properly priced, then what of investment planning disciplines that ignores these risks and effectively extrapolate the returns of the past into the future.   Ultimately, even MPT devotees are forced to use historical return relationships to forecast the future, because this is the only “equilibrium” they know.      

I provide an excerpt from an Ibbotson Associates report “Stock Market Returns in the Long Run: Participating in the Real Economy” which elucidates some of my concerns.

We forecast the equity risk premium through supply side models using historical information.   Contrary to several recent studies on equity risk premium that declare the forward looking equity risk premium to be close to zero or negative.  The equity risk premium is estimated to be 3.97% in geometric terms and 5.90% on an arithmetic basis. This estimate is about 1.25% lower than the straight historical estimate.…..Also our models interpret the current high P/E ratios as the market forecasting high future growth, rather than a low discount rate or an overvaluation.  Our estimate is in line with both the historical supply measures of the public corporations (i.e., earnings) and the overall economic productivity (GDP per capita).

Our estimate of the equity risk premium is far closer to the historical premium than being zero or negative. This implies that stocks are expected to outperform bonds over the long run. For long term investors, such as pension funds or individuals saving for retirement, stocks should continue to one of the favored asset classes in their diversified portfolios. Due to our lowered equity risk premium estimate (compared to historical performance), some investors should lower their equity

But what of the past performance of markets?  The following shows the real capital value of the S&P 500 from January 1997 to May 2012, and is taken from Robert Shiller’s data. 


Many European markets have fared even worse, as has the Japanese market.  Additionally, a great many investors depend on their their equity capital for dividends and do not have the luxury of reinvesting and compounding dividends at lower valuation levels. 

If we look at real dividend growth on the S&P 500, we find that this has fared slightly better than its capital return, but in real terms, today’s real S&P dividend as a percentage of its January 1997 index value is 2.4%, of its July 1997 value, 2%, and of its March 2000 value 1.7%. 

What has invariably made things worse for investors is that their investment planning and withdrawal strategies have been based on far higher real return assumptions. These return assumptions I might add were too high and emboldened by modern portfolio theory dogmas and belief in efficient markets.    This is not something i am saying in hindsight, I was making these concerns known at the time and modelling risk/return assumptions that ex post have more closely mirrored actual returns than MPT assumptions.

Modern portfolio theory knows nothing and everything about the future (the future is uncertain but it knows the probability of the distribution, its mean, standard deviation and covariance) but knows everything and nothing about the present (all information is known and no analysis needs to be conducted by those using inferential statistics to construct, plan and manage portfolios).

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